Financial Accounting

sixth edition-2019

Chapter-3 “Accrual Accounting Concepts”

 Contents (Learning Objectives)
❖ What is Accounting ? And How does Accounting Work?

❖ (3.1) Timing issues

Differentiate between the cash basis and the accrual basis of accounting

❖ (3.2) Revenue recognition criteria

Explain criteria for revenue recognition and expense recognition
❖ (3.3) The basics of adjusting entries
Explain why adjusting entries are needed and identify the major types of adjusting entries
❖ (3.4) Adjusting entries for prepayments
Prepare adjusting entries for prepayments and accruals
❖ (3.5) The adjusted trial balance and financial statements
Describe the nature and purpose of the adjusted trial balance
❖ (3.6) Closing The Books
Explain the purpose of closing entries
❖ (3.7) Summary of accounting cycle
Describe the required steps in the accounting cycle
❖ (3.8) Adjusting entries
Describe the purpose and the basic form of worksheet

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What is Accounting ?
✔ Accounting is the processor keeping the accounting book of the financial transactions

✔ Measuring, Processing, and Sharing financial and other information about businesses and corporations

How Does Accounting Work ?

✔ Accounting is one of the most important things a business does.

✔ The operations, financial status, and cash flows of a large organization over a certain time period are summed up in
the financial statements.

✔ All the transactions based on hundreds of individual financial transactions.

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 Chapter Review [Accrual accounting concepts]

The basics of The adjusted Summary of Adjusting

trial balance Closing the
Timing issues adjusting the accounting entries – using
and financial books
entries cycle a worksheet
statements
• Accrual • Types of • Preparing
versus cash • preparing the
adjusting adjusted trial closing entries
basis of entries • Preparing a
accounting balance
• Adjusting • Preparing post-closing
• Revenue trial balance
entries for financial
recognition prepayments
criteria statements
• Adjusting
• New
entries for
accounting accruals
standard for • Summary of
revenue basic
recognition relationships
• Expense
recognition
criteria

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3.1 Timing Issues

Accountants divide the economic life of a business into artificial time periods.
This is the accounting period concept .Accounting periods are generally a
month , a quarter ,a half a year or a year .

Jan Feb March Apr May June Dec

month
A quarter
A half a year
A year

Helping hint: An Accounting time period that is 1 year long is called a financial year.

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 Cash Basis Accrual Basis

● Revenue recorded when cash is

● Revenue recorded when earned.
received.

● Expenses recorded when cash is paid. ● Expenses recorded when agreed upon.

● Easier to use, gives an accurate ● More complicated, does not give an

measurement of current cash in hand accurate measurement of cash in hand

● Better for small Business ● Better for Large Business

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Accrual Versus Cash based Accounting
Cash Basis Accounting

For example, if a company provides a service in December but doesn't receive the payment until January,
the revenue is recorded in January under the cash basis, when the cash is received.

Accrual Basis Accounting

For example, if a company provides a service in December, even if the payment is received in January, the
revenue is recorded in December under the accrual basis, when the service was performed.

Basic Accrual Basis of Accounting Cash Basis of Accounting

Both cash and credit transactions are

1.Recording of Transaction Cash transactions are recorded.
recorded.

Prepaid and Accrued expenses are

accounted for in the profit and Loss Prepaid and Accrued expenses are not
2.Prepaid/Accrued Expenses
Account. adjusted. Similarly accrued Revenue/
Accrued Revenue/ Revenue received in
Accrued Revenue/ Revenue received in Revenue received in advance
advance
advance are accounted and shown in are not adjusted.
the Balance Sheet.

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3.2 Revenue recognition criteria

• A definition of revenue is helpful in determining what is to be recorded as revenue ,but we also need
guidelines on when to record or recognize revenues
• The recognition criteria for elements of financial statements are helpful in determining when to record
amounts.
• Revenues should be recognized when and only when :
(a) it is probable that any future economic benefits associated with the revenue will flow to the entity and
(b) The revenue can be measured with reliability .

Generally, revenue should be recognized in the accounting period in which

the service is performed or the goods are delivered.

Companies recognize revenue in the accounting period in which

it is earned.

In a service enterprise, revenue is considered to be earned at

the time the service is performed.

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New accounting standard for revenue recognition

The new revenue recognition standard eliminates the transaction- and industry-specific revenue
recognition guidance under current GAAP and replaces it with a principle- based approach for determining
revenue recognition.
According to IFRS criteria, the following conditions must be satisfied for revenue to be recognized: Risk and
rewards have been transferred from seller to the buyer. Seller has no control over goods sold. The collection of
payment from goods or services is reasonably assured.
The Financial Accounting Standards Board (FASB) created a five-step process:
1. Identify the Contract with a Customer
2. Identify the Performance Obligations
3. Determine the Transaction Price
4. Allocate the Transaction Price to the Performance Obligations
5. Recognize Revenue when or as Performance Obligations are satisfied

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Relationships between revenue recognition, expense recognition and the accounting period concept

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3.3 The Basis of adjusting entries

In order for revenues and expenses to be records in the correct accounting period ,
adjusting entries are made to revenue and expense accounts at the end of the
accounting period.
Adjusting entries are needed to ensure that the recognition criteria are followed for
assets, liabilities revenues and expenses.
• The use of adjusting entries makes it possible to produce accurate financial statements
at the end of the accounting period.

• Adjusting entries make it possible to report correct amounts on the financial position
and on the statement of Profit or loss.

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Type of adjusting entries

Prepayments
1. Prepaid expenses: Amounts paid in cash and recorded as assets unit the economic benefits are used or consumed.

2. Revenues received in advance : Amounts received from customers and recorded as liabilities until the services are performed
or the goods are provided and revenue is recognized.

Accruals
1. Accrued revenues: Amount not yet received and not yet recorded for which
the goods or services have been provided .

2. Accrued expenses: Amount not yet paid and yet recorded for which the
consumption of economic benefits has occurred.

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3.4 Adjusting entries for prepayments and Accruals

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The basic of Adjusting Entries
Types of adjustment Account Before adjustment Adjusting entry

prepaid expenses Assets overstated Dr. Expenses

If amount paid is initially recorded as an asset Expenses understated Cr. Assets
If amount paid is initially recorded as an expense Dr. Assets
Expenses overstated
Assets understated Cr. Expenses

Revenue received in advance Liabilities overstated Dr. liabilities

If amount paid is initially recorded as an liability Revenues understated Cr. Revenues

If amount paid is initially recorded as an revenue

Revenues overstated Dr. Revenues
Liabilities understated Cr. liabilities

accrued expenses Expenses understated Dr. Expenses

Liabilities understated Cr. Liabilities (Payable)

accrued revenues Revenues understated Dr. Assets (Receivable )

Assets understated Cr. Revenues 15
Adjusting Entries Examples
Sr.No Adjustments need to be made Amount
1 Rent for April paid during March 10,000.00

2 Due date of Electricity bill for March is April 5 35,000.00

3 A customer made some payments in advance 10,000.00

4 A customer of Alibaba, gone bankrupted. Amount becomes ir-recoverable from this customer is 50,000.00

5 Salaries for previous month paid on 5th of next month 50,000.00

Date Particulars Debit Credit

31- Mar Prepaid Rent A/C 10,000.00

To Cash 10,000.00

31- Mar Electricity Expense A/C 35,000.00

To Accrued Expense A/C 35,000.00

31- Mar Cash 10,000.00

To Unearned Revenue 10,000.00

31- Mar Bad debts A/C 50,000.00

To Accounts Receivable A/C 50,000.00

31- Mar Salaries A/C 50,000.00

To Accrued Expense A/C 50,000.00

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3.5 The adjusted trial balance and financial statements

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Trial balance and adjusted trial balance compared

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Preparation of the Income Statement and Retained Earnings statement from the adjusted trial balance

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Preparation of the financial Position from the adjusted trial balance

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3.6 Closing The Books
Preparing closing entries

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Preparing closing entries

In addition to updating Retained Earnings to its correct ending balance, closing entries produce a nil balance
in each temporary account. As a result , these accounts are ready to accumulate data about revenues, expenses
and dividends in the next accounting period that is separate from the data in the previous periods.
Permanent Accounts are not closed at the end of the period . Closing entries are recorded in the general
journal and then posted to the general ledger.

Posting of closing entries

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Posting of closing entries

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Preparing a post- closing Trial Balance

Post-closing trial balance is a list of permanent accounts and their balance from the ledger after all
closing entries have been journalized and posted.

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3.7 Summary of accounting cycle

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3.8 Adjusting entries - using a worksheet

• A worksheet is a multicolumn from that may be used in the adjustment process and in preparing financial
statements
• A worksheet is not a permanent accounting record: it is neither a journal nor a part of the general ledger.
• It easier to prepare adjusting entries and the financial statement

Sample Form of a worksheet

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Q
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